- The US economy continues to prove far more resilient than expected despite the Federal Reserve’s efforts to cool it to rein in inflation. The labour remains tight although it is starting to show some signs of weakness. Nonfarm payrolls rose by 275,000 in February, and the unemployment rate increased to 3.9%, while the participation rate — the share of the population that is working or looking for work — held at 62.5% for the third consecutive month, and the employment-population ratio was little changed at 60.1%. Average hourly earnings for nonfarm employees rose by 0.1% in February and 4.3% over the year, still above the level the Fed said is necessary to achieve the 2% inflation target. Retail sales were up 0.6% month-over-month in February 2024, following an upwardly revised 1.1% fall in January. However, US consumer sentiment fell in March with the UoM consumer sentiment index edging down to 76.5, the lowest in three months, from 76.9 in February.
- US inflation came in hotter than expected in February at 0.4% m/o/m and 3.2% from a year ago. The monthly measure was in line with expectations while the 12-month reading was slightly higher. The core CPI rose 0.4% on the month and was up 3.8% on the year. Both were one-tenth of a percentage point higher than forecast. The dollar is likely to remain supported by a still strong economy. The Fed’s new dot projections showed an acceleration on December’s forecast with GDP growth this year now forecast to be at a 2.1% annualised rate, up from the 1.4% estimate in December. The unemployment rate forecast moved slightly lower from the previous estimate to 4%, while the projection for core inflation as measured by personal consumption expenditures rose to 2.6%, up 0.2% from December’s projection. Core PCE inflation is expected to get back to target by 2026, same as in December.
Yield curves
The Fed kept overnight federal funds rate at the current range of 5.25% to 5.5%. This decision marks the fifth consecutive meeting at which FOMC members opted to hold rates steady. It kept the federal funds rate at the highest target range in over 22 years. However, the Fed did change their December projections, now indicating up to 3 cuts this year. It also raised the neutral rate by 0.10, from 2.5% to 2.6%. Following the meeting, according to CME Group’s Fedwatch gauge, futures markets priced in a nearly 75% probability that the first cut comes at the 11-12 June meeting. However, despite the Fed’s apparent expectations of a soft-landing driven by continuing GDP growth as the labour market is expected to remain tight, with unemployment only forecast to rise to 4% by the end 2024, there may be some bumpiness along the way. Increasingly investors are pricing in the possibility of a no landing scenario, which would mean that . The March consumer confidence index came in below expectations at 104.7, essentially unchanged from February's downwardly revised 104.8 (was 106.7). In short, the risk of “no landing” or at least a bumpier landing may be increasing. It is clear that what the Fed wants to avoid is cutting rates too soon if the economy continues to grow at pace and/or global geopolitical events cause supply chain disruptions or, as noted by the New York Fed, China’s efforts to boost its manufacturing and steady its real estate market, lead to increasing global commodity prices which could put “meaningful upward pressure” on US inflation. The Fed’s preferred gauge of US inflation, the PCE index, eased to 2.4% in January — less than half what it was a year earlier, but was still above the 2% target. Markets will be looking very closely at Friday's release to determine if rate cuts will indeed begin in June or be pushed out to July or beyond. Atlanta Federal Reserve President Raphael Bostic has said he now expects just a single quarter-point interest rate cut this year versus two cuts that he had projected previously, due to persistent inflation and stronger-than-anticipated economic data.The Fed also looks set to slow down its quantitative tightening (QT) somewhat sooner than previously expected although, as Fed Chair Jerome Powell said, it wants to avoid some of the stresses that emerged the last time it was conducting QT.
The yield on the 2-year Treasury note, which is highly sensitive to movement of the Fed Funds rate, is at 4.58%, barely up from February’s 4.57%. The benchmark 10-year US Treasury note yield has fallen to 4.19% from January’s 4.26%, while the yield on the 30-year bond has also fallen to 4.37% from February’s 4.44%
Yield swings
Treasury yields in March shot up following higher than expected US inflation data, but have edged back down as markets adjusted to rate cuts being pushed out to at least June and the number of rate cuts also being downgraded. An interesting note is that the US curve inversion, the Treasury yield curve that plots two-year and 10-year yields, has been continuously inverted since early July 2022. Normally this does signify higher recession risk, something that the US economy continues to defy.
Global Economic and Market Review
The global economy is growing at a solid pace, led by the US. Although the UK is officially in recession, with Q4 2023 growth falling 0.3% in the final three months of 2023, following a 0.1% decline in the third quarter, there are signs that it will have ended in Q1. UK retail sales were stronger than expected in the first two months of the year as the volume of goods sold in shops and online was unchanged last month after a 3.6% gain in January, which was revised up by 0.2 of a point. Following on from the BoE meeting earlier in March, BoE Governor Andrew Bailey, said that “things are moving in the right direction” in the UK. Inflation rose by 3.4% in the 12 months to February 2024, down from 4.0% in January. On a monthly basis, CPI rose by 0.6% in February 2024, compared with a rise of 1.1% in February 2023. Core inflation, which excludes food and energy, fell from 5.1% in January to 4.5% in February. Services inflation, usually viewed as a stronger measure of domestic price pressures, CPI services annual rate eased from 6.5% in January to 6.1% in February. The labour market remains tight, with the unemployment rate for November 2023 to January 2024 at 3.9% and largely unchanged in the latest quarter. Wage growth came in at 6.6%. Markets are expecting the first rate cut in August.
In the eurozone ECB policymakers have delayed discussing rate cuts, citing wage growth concerns although wage growth appears to be slowing. However, ECB Chief economist Philip Lane said that once the ECB becomes more confident that wage growth is slowing and inflation is indeed heading back to the 2% target as projected, it can start discussing rate cuts. The ECB has placed a strong emphasis on first quarter wage data, due out in late May, suggesting that the rate path is unlikely to be clear for some time yet. Compensation per employee declined to 4.6% in the fourth quarter from 5.1% three months earlier but remains well above the 3% level the ECB considers sufficient to meet the 2% inflation target. In terms of eurozone business activity, the eurozone composite PMI increased from 49.2 to 49.9 in March, the best reading since June last year. Services PMI increased from 50.2 to 51.1.
The gap between Italy and Germany's 10-year yields, a gauge of investor sentiment towards the eurozone's more indebted countries, is, according to Worldgovernmentbond.com, 131.3 basis points(bps), -13.2 bps this month. This may be reflective of the poor state of the German economy, known as the eurozone’s manufacturing powerhouse, which is continuing to experience weak external demand, limited consumer spending, and reduced domestic investment brought about by high borrowing rates. As noted by the Financial Times, five of Germany’s top economic institutes have slashed their growth forecasts for Germany this year to 0.1%, down from their 1.3% forecast six months ago. Germany’s economy shrank 0.3% in both the fourth quarter and over the whole of 2023, making it the world’s worst performing major economy last year. The HCOB eurozone Manufacturing PMI fell to a three-month low of 45.7 in March 2024 from 46.5 in February, well below market forecasts of 47.
As core inflation has proved stickier than central banks have expected and the likelihood of rate cuts by the Fed get pushed back to at least June, when ECB rate cuts are also expected, there are other risks that shouldn’t be ignored that may have longer term consequences for inflation and yields. These include ongoing geopolitical fragmentation that may affect global trade and supply chains as companies look to reshore, friendshore and nearshore their production, demographic change which will continue to affect the structure of labour markets, the tightness of those markets and the consequent impact on wages and inflation, and the low-carbon transition which may result, in the short to medium term, in higher energy prices. All of these factors are likely to make inflation more volatile.
However, despite these risks, overall markets seem to be accepting that rates will remain higher until at least the summer. Markets are still counting on a softer landing as being the base case scenario although there are increasing concerns that we may face a “no landing” scenario which implies maintaining a much higher rate environment than experienced in previous monetary policy cycles. Given the growing degree of volatility, with bond markets seemingly more sensitive to all economic data, shorter duration bonds may continue to be preferred by investors.
Key risks
- Inflation fails to fall in line with projections, weighing on asset prices. It is highly anticipated that the Fed, the ECB and the BoE will begin to cut rates in early to late summer 2024. The cut by the Swiss National Bank last week . However, there is the possibility that cuts are later and fewer should the trend in strong economic data persist. The Fed may not be able to get to the 2% target this year due to possible demand pull inflation, which means that the dollar will remain strong and yields may continue to rise. There are also risks that headline inflation may rise, particularly if Chinese policies, aimed at supporting manufacturing growth and the property market, lead to a surge in commodity and other creating inflationary pressures. We may also see the correlation between the eurozone and US curves continue to weaken, particularly at the short end, as the growth narrative for the two regions still differs due to the structural differences and differing geopolitical and resource access risks.
- Policymakers mistiming on credit loosening leads to recession or reinflation. The question on European growth and the fact that productivity has not picked up there as it has in the Us could cause the euro to continue to fall against the USD. Recession across the eurozone is unlikely although the slowdown in Germany and slower growth in France may weigh heavily on the eurozone. In the US the strong economy, driven by the still tight labour market, seems to indicate that markets and the wider economy are perhaps less rate sensitive. Therefore the timing of Fed cuts may prove critical as too early a rate cut in such a buoyant environment or if inflation is imported due to Chinese actions as suggested by the New York Fed, may make markets go into panic mode if the Fed had to reverse any policy change.
- Geopolitical tensions and events.These include not just the ongoing tensions in the Middle East with a lack of a ceasefire between Israel and Gaza despite the UN resolution, nor the continuing attacks in the Red Sea from Yemen’s Iranian-backed rebel Houthis but also include the ongoing war in Ukraine, the tensions between NATO and Russia, which are likely to be emphasised further in the upcoming EU parliamentary elections, and the likelihood of increasing tensions between the US and China as the US moves further into its election cycle and both Presidential contenders seek to outline potential actions against Chinese industrial policy and the industries it supports, notably in the tech sector.
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